In a previous article (Renaissance, Dec 2001), the author
has argued against the abolition of interest through a legal decree. Here,
he proposes a strategy for this abolition. (Editor)

Proposed Strategy

Should we conclude that since there had been no success
in eliminating interest from the economy in the past, we shall also not
succeed and hence we should try to live with it? No. This would be a
defeatist answer. The main point of our argument is that in the past people
tried to eliminate interest through a legal decree. They did not succeed.
Trying to do so now would also not succeed. We need to re-think our
strategy. Our proposed strategy consists of three elements:

1. Creating enabling legal infrastructure for Islamic finance

2. Changing economic policies

3. Managing the change

1. Creating Enabling
Legal Infrastructure For Islamic Finance

If we have to eliminate interest from the economy, we
need to create an alternative system of finance. There is no disagreement on
this. The present proposal says that instead of creating a law to prohibit
interest, we should concentrate in creating an alternative system of finance
which should freely compete with the interest-based system. Only through
free interaction, and based on the results of its operations, people should
freely decide to adopt the Islamic system and discard the interest-based
system. The interest-based system should become redundant through a
voluntary process of human behavior rather than through the enforcement of
law.

Muslim scholars have done commendable research in proposing an alternative
basis of Islamic finance. Some of the more popular modes of finance and
investment are: Murābahah, Mudārabah, Mushārakah, Ijārah, Ijārah wa Iqtina‘,
Bay‘ Silm, Bay‘ Istisnā. There are several variations, combinations and
permutations of these modes. A lot of valuable work has also been done in
financial instruments engineering. The appropriate approach would be to
create a legal infrastructure that defines the rights and obligations of
various parties under each type of transaction. The people should have
certainty and confidence in the system. The judicial system should provide
all the assurance that dealing in Islamic finance would not lead to undue
risk, fraud, or deception. The system of Islamic finance should operate side
by side with the interest-based system. It would generate a genuine
competition among the two systems. It would be possible for the Islamic
system to demonstrate, if it is really a better system, with its results
that dealing in Islamic finance makes economic sense. It would be at that
stage that the people would turn to Islamic finance with their free will. At
that time, the Islamic economists would no longer append the famous crutches
of creating the Islamic system first and then abolishing interest. The
result would attract people and it would not be necessary to be a Muslim
for benefiting from the Islamic system. For this reason, we believe, the
probability of successful elimination of interest from those economies where
the two systems are operating side by side is higher than where it is being
attempted as a global legal solution.

Need not be said that the State Bank of Pakistan should
act as a regulator for Islamic financial institutions, as it is a regulator
for conventional banks.

2. Changing Economic
Policies

For eliminating interest through an economic process,
rather than by a legal decree, we need to make several changes in our
economic policies. The objective of change would be to reduce the rate of
interest to zero without interfering artificially with free market forces.
The discussion below is only indicative of the direction that the economy
should take. In actual practice, the professional economists should consider
this question in greater depth. The question is: what are those economic
changes that would help reduce the rate of interest gradually until it
withers away as an economic factor? Some tentative ideas are as follows:

One of the elements in the rate of interest is the
compensation to cover the bad debt risk. The market conditions should be
regulated in such a manner that the phenomenon of bad debt is minimized. Bad
debt is a complex issue. Bad debts take place due to several reasons such as
dishonesty, natural calamities, sudden market down turns due to innovations,
business failure due to bad management, etc. The objective of economic
planning should be to curtail the possibilities of bad debts. Necessary
legal as well economic changes would be required to create circumstances for
overcoming business failures. Perhaps we can never create circumstances
where businesses would not fail. But if we were able to reduce this risk,
the rate of interest would come down.

One of the reasons for interest to sustain in the economy is the dearth of
lent funds. If we are able to increase the size of savings, we can increase
the supply of lent funds. Again, savings are a function of a whole lot of
factors such as income level, transaction needs, emergency needs and
investment needs of the savers. The distinctive feature of Islamic teachings
is that it attaches a very high value to simple and frugal living. For
increasing the level of savings, people will need to bring a change in their
lifestyles. Simple and contented living can help. In this area, Islamic
teachings can provide a good base.

The supply of lent funds can also be increased by suitable monetary policy
measures, such as reducing the reserve requirements by the central bank.
This by itself is linked to the prudential requirements of the central bank.

One of the reasons that interest is sustaining in the economy is that people
with fixed income, pensioners, widows, and other low-income groups need a
risk-free return on their savings. Abolishing interest by a law would hit
them very hard. For this purpose, we need to strengthen the system of social
security and income maintenance. Some of the measures in this area would be:

Reviewing the pension system of government employees, enabling them to
contribute to pension funds which are nvested during their active service
enabling the employees to get pension at a higher rate than what the
government can pay. This would require a good deal of actuarial work and
also a suitable climate for investment of funds.

Reviewing the provident fund system on the lines suggested above in the
case of pension funds.

Creating the infrastructure for providing a house on ownership basis by
the time a person retires from service. This type of scheme is in vogue in
the Pakistan defense forces and can be expanded with some initiative and
skill.

Streamlining Zakāh and other social security systems so that the poor
people do not have to depend on interest income. Instead, they should be
able to make a living through Zakāh finance. An important feature of this
policy should be to rehabilitate the poor rather than to feed them on
continuous charity.

Ensuring an effective system of distribution of inheritance can also help.
This would require effective implementation of inheritance laws,
especially, in favor of women and minor orphans.

Land reforms for empowering the landless. It would require major legal and
social changes to enable poor people to sustain through land cultivation
rather than looking up to interest income.

The limited liability of the debtor increases risk of debt for the lender
since the lenders’ position is insecure in case of default. The lenders
would like to cover themselves against this risk. Therefore, they add a
premium to the interest rate for this risk as well. If we have to eliminate
interest from the economy, we should also do away with the concept of
limited liability. This would lead to reduction in the market rate of
interest from the two sides. Firstly, it would reduce the risk of the loan
for the lenders. They would have a greater assurance of recovery of their
principal. Thus they would not need to add a premium to cover this risk.
Secondly, the debtors would also be careful in getting the loans. In case of
limited liability, the debtors have the tendency of contracting loans
recklessly. Such a tendency would be put to rest. As a result, the demand
for lent funds would be reduced. This would also lead to a reduction in the
rate of interest.

The credit risk is of two types: debtor-specific and system-specific. The
debtor-specific risk refers to the specific circumstances of a debtor, or
his capability to pay back the debt. The system-specific risk refers to the
environment and condition of the economy, both internal as well external.
Examples are inflation, exchange rate fluctuations, trade-deficit,
technological changes leading to business slump in a certain industry, etc.
If an economy has to reduce or eliminate interest, it must adopt such
policies as would reduce the system-specific risk to the lenders. The
debtor-specific risk, perhaps, cannot be reduced by any state policy. This
would always remain a concern of the creditor.

A decline in the interest rate forces the capitalists to search for better
opportunities. It persuades them to look for opportunities in the real
sector and they are tempted to undertake equity investment. An evidence of
this phenomenon can be seen in the increased inflow of FDI during 1990s. One
of the reasons for such an increase in the FDI was a general decline in the
international interest rates. It made business opportunities in the
developing countries more attractive to the investors.1
Therefore, once the rate of interest goes sufficiently low, it would make
the investors think for other options. This would discourage investment on
interest. Instead, the investors would be tempted to look for non-interest
based but real sector-based options. Thus lowering of interest rate would
set in motion a benevolent cycle, which could reinforce itself.

The environment for FDI has become extremely favorable. Over years, the FDI
has increased several folds. The reason is that the average return from FDI
has been higher than from investment on interest. It shows that no amount
of legislative changes would do as much as the sheer profit motive can do.
So long as it is more profitable to invest in business, people would tend to
invest on the basis of equity-participation. The evidence of FDI is
sufficient to prove this point. There has been an upsurge in the FDI
recently, despite global financial crises. The FDI flows which remained
resilient during this crisis have now become the single largest source of
more stable and reliable long term development finance for the developing
countries. These flows have expanded from $35 billion in 1991 to $ 131
billion in 1996 and $ 192 billion in 1999.2”
…FDI to developing countries, which proved resilient in 1998 and 1999, is
likely to increase to about $ 200 billion in 2000 and $ 215 billion in
2001,…3 ….FDI is now the single
largest source of capital flows to developing countries.4”

Several factors have helped increase the level of FDI. Some of them are
openness in financial flows, liberalization of investment rules in
economies, improvement in technologies relating to transportation,
communication and adoption of sound economic policies such as strengthening
contract enforcement, reduction in the risk of nationalization, and liberal
rules to transfer dividend incomes. These very factors can help increase
investment in the real sector domestically and discourage interest-based
investment.

There are four reasons for charging interest in the capitalist system: a)
inflation; b) risk; c) administrative expenses of the lender; d) pure
interest as return for allowing use of the money. So far as the first two
are concerned, proper economic policies and regulatory and legal framework
need to be developed to reduce them to near zero. Once we are able to reduce
the risk to the lender to zero, he cannot claim a return on his money due to
risking of the loan. Similarly, if we are able to bring down inflation to
almost zero, the claim for interest does not remain legitimate. The
administrative costs to the borrower remain a legitimate claim. Almost all
Islamic economists accept that the banks can demand service charges for
providing various services to the borrowers. But they should not be related
to time or to the principal sum lent. They can and should be equal to actual
cost. They should not be a source of earning profit. Once we are able to
take care of the three items, the rate of interest would be reduced to the
level of pure rate of interest. This rate would have to compete with return
on investment on the basis of equity. In all probability, so far as the
empirical evidence goes, the return on equity would be higher than the rate
of interest. Interest would become unattractive for everybody.

At present, the taxation laws accept interest as an admissible expense
while treat profits to be distributed as dividends as taxable income of the
companies. As a result, there is an incentive for the companies to borrow
money on interest and reduce their tax burden. This is a negative incentive
for investment on equity basis. If we aim at discouraging investment on
interest, the incentives need to be reversed. The interest to be paid should
be made taxable and profit to be distributed should be exempted from tax.
However, we can make the dividend taxable as part of the income of the
recipients. The interest earnings of the individuals and corporations should
be taxed heavily, and tax rebate should be given to the dividend income. It
will discourage people to invest their savings in interest-bearing assets.
At the same time, people will be encouraged to place their savings in
equities.

Another taxation reform could be to penalize the debt-finance by levying
higher tax rates if a business firm finances more than a certain percentage
through debt rather than equity. Or a tax relief could be given to firms
that raise more than a certain percentage of their capital through equity or
equity-related modes of finance as compared to debt or debt-related modes.

Interest-based debt finance is supported by several legal, social and
economic institutions. Part of the risk of the creditors is passed on to the
tax-payers (society) in general without any explicit agreement of the
people. For example:

(One) The institution of limited liability restricts the liability of the
borrower to the extent of his capital. If he defaults, his debt beyond his
own capital will be passed on to the creditors. This encourages the people
to keep on incurring debt recklessly.

(Two) The central bank acts as a lender as the last resort. Thus part of
the risk is covered by the central bank. The banks can always rely on it
in case of difficulty. As a result, they can adopt, at times, a careless
attitude while extending loans.

(Three) Deposit insurance provides a cover to the depositors. The banks
need not worry about the money of the depositors. In case, because of the
careless attitude of the banks, the bad debts accumulate, the depositors
do not suffer. So the banks need not worry about that.

(d) The insolvency laws also provide a safety valve to the borrowers. They
are required to repay the loans to the extent of the available assets.

These are some recommendations regarding economic policies that need to be
changed if we aim at eliminating interest from the economy through an
economic mechanism.

3. Managing The Change

Elimination of interest from the economy would change a
large number of economic relationships. It would require a careful strategy
for managing the change. We have discussed this question in greater detail
elsewhere5. In the following
passages, we summarize some of the suggestions made earlier.

The government has already established a permanent Commission for the
Islamization of the Economy. One of the primary mandates of the Commission
is to eliminate interest from the economy. But the Commission needs to be
strengthened. All its members including the chairman are working as an
additional responsibility to their full-time jobs. For example, the chairman
is the Minister for Religious Affairs, which is a large ministry within the
federal government. Similar other members are busy in their respective jobs
and attend the meetings of the Commission on request. Thus the mechanism to
bring such an enormous change is at best a part time institution. Of course,
the Commission has a secretariat but it provides secretarial support and is
not responsible for any actual policy formulation. We would, therefore,
suggest that a permanent Commission should be established with proper legal
support and full-time members to act as a conduit between the actual
execution and the overall oversight by the Parliament. Before we discuss the
role and functions of the Commission, we would like to emphasize the need
for a comprehensive legal framework for implementing alternative modes of
finance and not for prohibition of interest. The present paper does not aim
at discussing the details of the legal framework. We shall, instead, delve
into the managerial aspects of the change. The Commission should have the
following organs:

The Chairman

The Sharī‘ah Supervisory Board

The Steering Committee

The Project Director

The Chairman

He should be a full-time chairman with the status of a federal Minister. It
means that his responsibility should be exclusive of other functions. The
chairman should be responsible for overall success of the venture. The
chairman will have the support of three other organs as discussed below.

The Sharī‘ah Supervisory Board

The Sharī‘ah Supervisory Board (SSB) should consist of qualified Sharī‘ah
scholars from all shades and schools. The main responsibility of the SSB
will be to see that the transactions purported to be based on Islamic
Sharī‘ah do conform to the Sharī‘ah. For this purpose, it should be
mandatory by law for all financial institutions dealing in Islamic finance
to get a clearance from the SSB for their standard contracts and financial
instruments. All innovations in transactions by these institutions will also
be cleared by the SSB from the Sharī‘ah point of view. Need not be said that
the SSB will have support of the technical staff so that there is no
communication gap between the SSB and the financial institutions. With the
passage of time, the government will bring such changes in the courses and
syllabi of the educational institutions that scholars with appropriate
qualification become available for handling the economic and financial needs
of the Islamic economy.

The Steering Committee

A steering committee of the project consisting of representatives from the
State Bank of Pakistan, the Economic Affairs Division, the Finance Division,
Banks, the Development Financial Institutions, the Auditor General, the
Bureau of Statistics and the Council of Islamic Ideology should oversee the
implementation of the whole project. The steering committee should be
responsible for all operational policies and continuous review of the
developments taking place in the economy because of the Islamization
efforts.

The Project Director

Project Director (PD), an officer of the rank of a federal secretary, should
be the chief executive of the project of Islamization of the economy. He
should have the necessary powers to carry out the work across various
sectors in the economy. The law should decide the powers and
responsibilities of the Project Director. In brief, he should not be
hamstrung by bureaucratic red tape. He would monitor the operations of those
financial institutions that choose to adopt Islamic finance as a mode of
their business. The Project Director should have four wings each headed by a
Deputy Project Director. The Deputy Projector Directors should have
following the Directorates under them:

a) Deputy Project Director-I:

i) Director General (Training)

ii) Director General (Media)

iii) Director General (Educational Institutions)

b) Deputy Project Director-II

i) Director General (Financial Institutions)

ii) Director General (Government Transactions)

c) Deputy Project Director-III

i) Director General (Sharī‘ah Audit)

ii) Director General (Economic Analysis)

iii) Director General ( Research & Development)

d) Deputy Project Director-IV

i) Director General (Finance)

ii) Director General (Administration)

The Deputy Project Director-IV will have the responsibility for finance and
administration. For others we give a brief description of their
responsibilities.

Director General (Training): He shall be responsible for the training
of banking staff and officers in the concepts, and mechanics of the Islamic
financial system. He shall develop appropriate teaching material and set up
training institutes for this purpose. Besides in-service training of the
banking staff, he shall also offer diploma and certificate courses for young
graduates to meet future staffing needs of the financial sector. These
courses will also be available to the personnel of other Muslim countries.

Director General (Media): He shall be responsible for developing a
close liaison with the television, radio and press of the country and
abroad. He shall develop programs, features, films and other promotional
material to introduce the concept of Islamic financial system. He shall also
respond to any unfair criticism of the change program and clarify the
official position. He shall encourage dialogue and debate in the media on
various aspects of the change program. He shall also prepare briefing
material for the steering committee and the chairman indicating such policy
changes as may be suggested by the media and the public.

Director General (Educational Institutions): He shall be responsible
for planning appropriate changes in the courses and syllabi of educational
institutions at all levels. He shall sponsor development of teaching
material for various classes that incorporate theoretical and practical
aspects of the Islamic economy. These books and other teaching material
shall be freely available for those institutions that opt to teach Islamic
economics to their students. However, the government educational
institutions will adopt this material as a mandatory component. He shall
also coordinate with private sector educational and training institutions
for offering training courses on Islamic finance through them.

Director General (Financial Institutions): He shall be responsible
for coordinating the operations of the financial institutions dealing in
Islamic finance. He shall oversee and evaluate the implementation plans of
the change over by various institutions. He shall be the first level
trouble-shooter for the financial institutions.

Director General (Government Transactions): He shall have the
responsibility of planning for the elimination of interest effectively from
all types of government transactions. It will involve reviewing of domestic
and foreign government transactions. He will also be responsible for
re-negotiating the existing government debt agreements and for making short
term and long term plans for eliminating interest from the future government
business. This will be a heavy charge and in practice more than one director
general may have to be assigned this responsibility.

Director General (Sharī‘ah Audit): The Director General (Sharī‘ah
Audit) will have the responsibility for ensuring that the financial
institutions purporting to offer Islamic finance ought to be doing so in
letter and spirit, and that the change is not merely in name. The Director
General and his staff could be drawn from the Auditor General’s department
and corps of Sharī‘ah scholars with the consent of the SSB.

Director General (Economic Analysis): He will be responsible for
collecting information on the state of economy regarding specified
indicators like saving, investment, prices, money supply, international
capital flows, stock exchange activity, etc. With the help of professional
economists, he shall develop periodic reports on the effects of Islamization
on various economic variables. His reports will be a major resource for
conceiving any strategic moves in the implementation plans.

Director General (Research & Development): He shall be responsible
for basic and applied research in the Islamization of the economy. At a
primary level, he should collect information on the actual state of
Islamization in the economy. But over a long term, he shall conceive
projects in creating new knowledge in this field. His reports will provide a
continuous source for improving the implementation of the project.

Some Related Issues

1. Leadership Role of the Government

The strategy proposed in this paper makes Islamization
of financial institutions a voluntary process. It perceives to eliminate
interest from the economy through an economic mechanism. The legal process
only supports the effort but does not make dealing in interest as illegal.
In this scenario, the question arises: what is the role of the state? Shall
it remain a silent spectator to the Islamization process or would it play
any active role in it. Our suggestion is that the government should play the
leadership role in eliminating interest from the economy. It should move in
the following direction:

The government should make a clear and unequivocal statement of its
intentions of introducing and supporting the process of Islamization of the
economy and elimination of interest.

It should initiate a planned effort to eliminate interest from its own
transactions. For example, it should eliminate interest from state provident
funds, inter-provincial financial transactions, loans to government
employees, loans from the State Bank of Pakistan, saving schemes, state
loans to public enterprises. For all these transactions, the government
should prepare a plan in collaboration with the Commission for Islamization
of the Economy and put these plans into practice over an extended period.

The government should decide in principle that it would not contract any
future loans on interest so far as it is possible.

The government should place before the legislature every year a detailed
report on the extent to which it was successful in eliminating interest from
its transactions.

The government should initiate economic and fiscal policies that encourage
elimination of interest from the economy and discourage dealings in
interest.

2 Adjudication of
Interest-based Contracts

An important question is about the role of courts in
adjudicating disputes arising from interest-based contracts and
transactions. Once we accept that Islam has prohibited interest, to what
extent should courts of an Islamic state continue adjudicating disputes
relating to interest claims? Ideally, the courts of the Islamic state should
not adjudicate these claims as these contracts were un-Islamic to begin
with. However, the contemporary scene is that all financial institutions are
based on interest. If the legal system of the country refuses to recognize
interest-based transactions, the financial institutions that are holding the
wealth of the entire society, would be without any anchor. There would be
total chaos. It is essential that such a situation should not arise.
Therefore, for some period of time the courts should continue adjudicating
the interest-based disputes. However, as part of the process of encouraging
Islamic finance, the government and other NGOs committed to this cause
should educate people about the harmful effects of interest and about the
benefits of Islamic finance. This should continue until a majority of
transactions of the financial institutions are based on an Islamic mode.
Since this has to be a voluntary process, it would be slow. It would take a
long period of time as the interest-based institutions have taken a long
time to establish and spread. Till then, the courts should continue
adjudicating cases relating to claims of interest or other issues relating
to interest based finance.

Concluding Remarks

Elimination of interest from the economy is not wholly a legal process.
Even if we pass a law to abolish it, it will not wither away. Economic
compulsions would sustain it, even though as a black-market phenomenon. If
we have to abolish interest, we would need to create such economic
conditions that would make interest redundant. It means that at the end of
the day, it should not be in the self-interest of the people to deal in
interest. The interest-based transactions should be more expensive as
compared to equity-based transactions. So, it should be a market-based
solution.

The dilemma of an ordinary person is that he does not have a fully developed
and reliable system of Islamic finance. Any threat to prohibit interest
without creating an Islamic infrastructure runs fear-waves in the hearts of
ordinary people. The appropriate strategy should be to develop Islamic
alternatives and make more options available. Let interest remain an option
for the people. People should decide for themselves to abandon it with their
free will. They should not be forced to do so.

Trying to eliminate interest from the economy through a legal decree is
effectively restricting the individual freedom to decide about his financial
behavior. This sacrifice of freedom should have adequate incentives for the
individual. The Islamic finance should operate in the economy and get
matured. It should create sufficient economic incentives for the people for
persuading them to forego their freedom to deal in any way they like.

The elimination of interest from the economy should be made effective
through an educational process. The government can play a leadership role by
providing necessary incentives in its various policies and by adopting
interest-free transactions in its own business.

The legal system should continue supporting the interest-based transactions
till the majority of the financial transactions in the economy are based on
Islamic rules.

The claims about superiority of the Islamic finance should be put to real
empirical test and people should experience it. Islamic finance should not
be adopted on the crutches of law. However, law should support the Islamic
financial transactions as it is supporting the interest-based system.

One of the implicit advantages of this approach would be that Islamic
finance would compete with interest-based finance. The competition would
enable the alternative system to refine itself in due course of time. In
fact, this is the natural approach for systems to take roots.